Loss leader

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For other pricing strategies and policies see: Pricing Strategies.

In marketing, a loss leader is an item that is sold below cost in an effort to stimulate other profitable sales. It is a kind of sales promotion. There are several varieties of this profitable technique which was pioneered by Thomas Edison in the early 1880s.

Contents

1 Sales of other items in the same visit

1.1 Characteristics of loss leaders

2 Sales of related items over time
3 History
4 Temporary promotions
5 Low margin products
6 Related Links

Sales of other items in the same visit

One use of a loss leader is to draw customers into a store where they are likely to buy other goods. The vendor expects that the typical customer will purchase other items at the same time as the loss leader and that the profit made on these items will be such that an overall profit is generated for the vendor.

An example would be a supermarket selling sugar or milk at less than cost to draw customers to that particular supermarket chain. Wal-Mart uses some toys as a loss leader, leading to the potential demise of toy-only competitors like Toys "Я" Us and FAO Schwarz. (See predatory pricing.)

Under some jurisdictions, this is considered dumping and is illegal.

A related example is the practice by some auto repair shops of offering required inspections at loss-leading prices; if a problem is found preventing the inspection from being passed, they are then in a position to offer to fix it.

Characteristics of loss leaders

A loss leader is typically placed at the back of a store, so that purchasers must walk past racks of other displayed goods which have higher profit margins.
A loss leader is usually a product that customers purchase frequently: thus they are aware of the usual price and that the offered price is a bargain.
Items offered as loss leaders are often bulky or perishable, making it difficult for the customer to buy in bulk so as to avoid repeat visits to the shop.
In some cases, loss leaders are placed on the floor or left dirty, scratched, or broken so potential customers get additional enticement to buy the "step-up" model.

Sales of related items over time

This is also known as the razor and blades business model, referring to the most famous example. Razor handles are sold at a loss, but sales of disposable razor blades are very profitable. American businessman King Gillette famously invented the razor and blades business model, in which safety razors were sold or even given away as loss leaders so that his company could profit by selling disposable razor blades.

This practice is commonly used with video game consoles. Here, the console is sold as a loss leader but the console developer makes a profit on licensing fees charged to game developers who wish to develop games for the console. This also translates to higher prices that are charged for the games and for original console accessories such as game controllers.

It also is used with the way inkjet printers are sold to retail customers. Again, the printers, especially the entry-level models, are sold at a loss-leading price which seems apparently affordable to most consumers, but they pay dearly for ink cartridges and specialty papers supplied by the manufacturer. This is augmented by clauses in the printer's warranty that use of cartridges not supplied by the manufacturer will void that warranty. Some manufacturers even use technological limitations so that the printer doesn't work if it is used with aftermarket cartridges.

Similarly, some bars or concession stands will offer free or inexpensive popcorn, then sell drinks at high prices to customers made thirsty by the popcorn.

In these situations, it can be harder for dealers who use "fruitshop"-style trading methods of purchasing to negotiate buying larger quantities of consumables at a lower price in order to sell them off cheaper.

Loss leaders are an important part of companies' marketing and sales strategies.

History

This business model was pioneered by Thomas Edison in the early 1880s shortly after he patented the first production incandescent lamp in 1879. The lamps were costing him $1.25 each to make and he offered to make them at $0.40 if the Edison Light Company would buy all their requirements from him during the life of the patent. In Edison's words according to Henry Ford who later wrote about it "The first year the lamps cost us about a dollar and ten cents each. We sold them for forty cents; but there were only about twenty or thirty thousand of them. The next year they cost us about seventy cents, and we sold them for forty. There were a good many, and we lost more money the second year than the first. The third year I succeeded in getting up machinery and in changing the processes, until it got down to so that they cost somewhere around fifty cents. I still sold them for forty cents, and lost more money that year than any other, because the sales were increasing rapidly. The fourth year I got it down to thirty-seven cents, and I made up all the money in one year that I had lost previously. I finally got it down to twenty-two cents, and sold them for forty cents; and they were made by the million. Whereupon the Wall Street people thought it was a lucrative business, so they concluded they would like to have it, and bought us out." Ford found this principle of manufacturing to be "most valuable."

Temporary promotions

Loss leaders can also be attempts to build a customer relationship. For example, a grand opening sale at a new store might lose money in hopes of creating customer interest and building customer loyalty. A new restaurant may serve larger or higher quality meals during its first couple of weeks of business than it plans on doing in the future. The high value meals act as loss leaders, creating a marketing buzz.

Low margin products

Some products are sold at very low profit margins, generating only minimal profit for the company. The reasoning is the same as the reasoning behind loss leaders. Technically, these products are not loss leaders because they do not generate a loss. Examples of these include:

The Wendy's fast-food chain has a "value menu" of low-priced items to draw customers to the restaurant, where they may decide instead to buy higher-priced sandwiches (or may buy sodas, whose true cost to the restaurant is almost nothing).
Convenience stores that sell gasoline often do so at very low margins, relying for profits on increased sales of snacks and coffee to stopping motorists. Competition for gasoline prices, especially in urban areas, is intense (especially since the prices are often readily visible to passing motorists) and as such it is hard to make a significant profit on selling gasoline.
Commercial vendors often release baitware at no charge as a loss leader to attract customers to other services or products available for a fee.
Some Internet-based music stores, most notably Apple's iTunes Music Store, also operate at low margins, with the intent of increasing sales of electronic devices such as the iPod.
Movie theaters make almost no money on tickets—ticket sales are largely passed on to the distributor. Theaters generate revenue by selling popcorn, candy, and drinks.
Video game console makers that sell their console units at very low margins, or even at a loss, to achieve a higher market share. They rely on profits from software sales where the markups are considerably higher. They also receive profits from 3rd party software companies for licensing fees. Microsoft has used this technique with the Xbox. Sony has done the same, to a lesser extent, with the PlayStation 2 and PSP.